Enhance your fixed income with emerging
market debt

Three reasons to look beyond traditional
sources of income

Summary

Canadian investment grade fixed income may no longer offer investors the income they need to meet their financial goals.

Investors should consider expanding their opportunity set with emerging market debt, which offers potential for higher yields, an enhanced risk/return profile and protection against rising interest rates.

1. The income dilemma

A typical Canadian investor has 82%1 of their fixed-income exposure at home, with 78%2 of this exposure in government bonds and money market funds. For
30 years this approach worked, as Canadian investment grade bonds provided attractive yields, plus the added benefit of price appreciation from falling interest rates. But it appears this generational opportunity has come to an end, leaving many Canadian investors with an income dilemma.

Current low yields and the potential for meaningfully higher interest rates mean Canadian investment grade bonds are unlikely to provide the total return profile investors have become accustomed to.

Investors may have a better chance of finding the income they need and mitigating the risk of rising interest rates if they expand their opportunity set to include emerging market debt.

The average coupon has declined, resulting in higher duration. This higher interest rate sensitivity, combined with lower income return, has reduced the total return potential of investment grade bonds.

2. Emerging market debt

A growing asset class that covers more than 70 countries and accounts for approximately US$16 trillion, emerging market debt offers a wide range of economic and interest rate environments. This translates into potential for (a) higher yields, (b) an enhanced risk/return profile and (c) protection against rising interest rates.

a. Higher yields

Emerging market debt has a higher yield profile than developed market investment grade bonds, which currently offer little to no yield. As Figure 1 shows, this is true of all three major emerging market asset classes:

Importantly, these periods include three significant “flight to quality” events, which would normally favour Canadian domestic investment grade bonds: the 2008 financial crisis, the 2013 taper tantrum, and the oil-price decline of 2015.

Emerging market debt is particularly beneficial when it complements a core portfolio of Canadian investment grade bonds. Over five years, a 15-30% allocation to emerging market debt offered an approximately
0.4 – 0.8% increase in annualized return while lowering overall volatility (Figure 2).

Another benefit of emerging market debt is that it is not wedded to any single interest rate cycle. Instead, investors can capitalize on opportunities in countries where central banks – responding to country-specific economic conditions – are currently maintaining or lowering interest rates. The policy rate diversity of emerging markets can help investors overcome the current low-yield environment at home and take advantage of the falling interest rates that benefited them for so long.

Source: PineBridge Investments as at August 31, 2017. Returns are annualized.

3. An active, on-the-ground approach

Emerging market debt offers the potential for higher yields and better risk-adjusted returns, as well as protection from rising interest rates. But with the evolution of these markets over the last 30 years, their risk factors have largely shifted from systemic – impacting the entire asset class – to idiosyncratic (i.e., country or sector specific).

As a result of this shift, it is more critical than ever to gain exposure to emerging markets through an active, risk-managed approach that:

Opportunistically targets the optimal portfolio composition for the current environment

Employs a dynamic security selection process that combines top-down analysis of the global macroeconomic environment with intensive bottom-up credit research

Is guided by managers with extensive experience in managing emerging market assets and an on-the-ground presence to help identify idiosyncratic opportunities and risks

Dealer use only.1 IMF, Bank for International Settlements December 31, 2016. 2 OSC April 2015.

The information provided herein does not constitute financial, tax or legal advice. Commentaries are provided by the portfolio manager or sub-advisor responsible for the management of the fund’s investment portfolio, as specified in the applicable fund’s prospectus (“”portfolio manager””). Statements by the portfolio manager represent their professional opinion, do not necessarily reflect the views of iA Clarington, and should not be relied upon for any other purpose. Information presented should not be considered a recommendation to buy or sell a particular security. Specific securities discussed are for illustrative purposes only. Mutual funds may purchase and sell securities at any time and securities held by a fund may increase or decrease in value. Past investment performance of a mutual fund or individual security may not be repeated. Statements that pertain to the future represent the portfolio manager’s current view regarding future events. Actual future events may differ. iA Clarington does not undertake any obligation to update the information provided herein.

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